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Should States Overhaul or Underfund Public Pension Funds?

The views expressed are those of the author and do not necessarily reflect the views of ASPA as an organization.

By Daniel G. Bauer 
April 22, 2016

Many scholars claim that during the last 30 years’, state and local governments have severely underfunded their defined pension plans. According to the Center for Retirement Research at Boston College, state and local government pension plans in 2011 were underfunded by $885 billion. In 2015, that number increased dramatically to more than $1 trillion. Others contend that if you look at the “fair market valuation” method used for evaluating private sector pension plan funding, the average U.S. public employee pension plan is only around 41 percent funded, while total unfunded liabilities were approximately $4.6 trillion as of 2011. In either case, one thing is readily apparent: state and local governments are facing some rather critical questions regarding funding defined benefits pension plans.

In order to assuage concerns of multiple stakeholders such as pensioners, taxpayers, voters, public workers and average citizens, the issue of overhauling or underfunding public pension funds has been building momentum. Contextually, there is nothing new pertaining to the status of public pension funds. Various states’ retirement systems’ defined benefit investment portfolios have been running underfunding balances on an annualized basis since the 1970s.

At this point completely overhauling public pension funds is neither pragmatic nor palatable. What do the issues of overhauling and underfunding suggest is at the root of the problem? The argument herein is adherence to efficiency may provide insight.

In order to understand the importance of efficiently managing public pension defined benefit investment portfolios, start with impact. According to Pensions & Investments Age, total asset size for the 1,000 largest retirement funds in 2015 approximated $9.055 trillion. Comparatively, the size of public pension funds is substantial as well. For example, the U.S. Census Bureau estimates that approximately 4,000 public sector retirement pension systems exist in the United States. The March 2015 Federal Reserve Flow of Funds Report noted these public pension plans comprised $3.8 trillion in assets as of the fourth quarter in 2014.

Supporting aforementioned plan assets are 14.4 million active working members/pensioners and 9 million retirees. Moreover, $228 billion in benefit distributions are provided annually, thus impacting the overall economy and influencing the money and capital markets. The issue of overhauling comes at some substantial social, economic, political and financial risk.

The impact of the unfunded financial health that state pension funds have upon the overall economy and potential growth prospects cannot be dismissed as merely being a result of suboptimal policy choices and a public sector problem. The argument proffered herein is that the cause, as well as a solution, may be tied back to some extent to adherence to the tenets of Markowitz’s “Modern Portfolio Theory and the Efficient Frontier.” Are public pension funds being efficiently managed and adhering to the tenets of efficiency and the risk versus return relationship?

Unfunded liabilities have been variously labeled “hidden cost.” In many states, the burden for those costs (unfunded liabilities) falls entirely on the government since most public employees only pay for part of the normal cost of the plan. According to Musgrave & Musgrave, when pensions are underfunded it creates an intergenerational equity issue. Basically an intergenerational equity question is raised when tomorrow’s taxpayers are paying for the benefits received by today’s taxpayers, and the future taxpayers don’t receive the benefits. In terms of unfunded pension liabilities, tomorrow’s taxpayers will be forced to pay more in taxes to help fund retirement packages—i.e., an intergenerational equity issue. Underfunding may continue creating a fiscal illusion. Yes, the state has a balanced budget. However, the public pension funds continue to accumulate underfunded pension liabilities.

According to Selling & Stickney, how you measure unfunded liabilities, and the associated assumptions made regarding a host of decision points (including rates-of-return), impact the amount of unfunded liabilities a pension plan faces. Do these investment strategies result in lower than expected investment returns and create intergenerational equity issues?

From an actuarial perspective, a plan may project investment returns to be a given rate and the actuaries then compare the given rate to actual return rate for a period of time. If the plan has earned what it said it would earn, actuaries determine that the investment return rates are accurate. However, actuaries do not compare the actual rate of return a plan earns to what it could have earned if different investment strategies and policy statements were employed. Are the investment strategies used by public defined benefit plans maximizing the rate of returns for any given risk level?

The issue of continuing to underfund public pensions needs to re-examine efficiency in terms of a set of tenets: risk aversion, diversification of investment choices, asset allocation, efficient markets, liquidity to pay current obligations and Markowitz’ Efficient Frontier. One can hypothesize that the difference between actual investment returns and projected investment returns could be attributed to the costs associated with investment strategies undertaken over a long-term period of time.

Author: Daniel G. Bauer has 30 years of large domestic corporate and international professional experience. He received an Executive MBA from the College of Business at Florida Atlantic University and a BBA in Finance from The University of Toledo, Ohio. Email: [email protected].

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The American Society for Public Administration is the largest and most prominent professional association for public administration. It is dedicated to advancing the art, science, teaching and practice of public and non-profit administration.

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